Shuffle - Desmond Lachman Resident Fellow Desmond Lachman

Martin Wolf's comment describes very well the truly awful trap in which Greece, Spain, Ireland, and Portugal now all find themselves after years of private sector spending excess. In particular, he does well to remind us that, stuck within the Euro-zone, which denies these countries the use of an independent exchange rate policy, the Euro-zone's periphery is now condemned to a very prolonged period of painful nominal wage and price deflation. Mr. Wolf's comment might have brought out more forcefully how dire is these countries' situation had he focused on the quantitative dimension of two aspects of their current macro-economic predicament.

The first relates to the enormity of the loss in wage and price competitiveness at the Euro-zone's periphery. Since the Euro's inception, Greece, Spain, Ireland, and Portugal have all lost over 30 percent in unit labor competitiveness with respect to Germany. This loss of competitiveness has been an important factor underlying the dramatic widening in these countries' external current account deficits to double digit levels as a percent of their GDPs.

Reversing such a large loss of competitiveness, without recourse to exchange rate devaluation and against a Germany that is wed to price stability, must necessarily involve many years of sub-par economic growth and extraordinarily high unemployment levels for these countries. This will surely test their political staying power where signs of political unease are already all too much in evidence. It will also highly complicate these countries' efforts to restore any semblance of fiscal sustainability by substantially eroding these countries' tax bases.

The second area where Mr. Wolf might have focused attention is on the quantitative dimension of these countries' parlous public finances. Greece, Spain, and Ireland all now have budget deficits at close to or above double digit levels as a percent of GDP. At the same time, their public debt levels are on paths that will soon place them at double the Maastricht 60 percent of GDP limit.

As a hapless Latvia is now finding out, trying to restore fiscal sustainability in the midst of a deep recession and without the policy instrument to spur exports is a fool's errand. For pro-cyclical public expenditure cuts only deepen the domestic recession. That in turn has the unfortunate effect of importantly offsetting the benefits of such cuts on the budget deficit by eroding the country's tax base.

Martin Wolf is right in suggesting that leaving the Euro-zone is not a realistic policy option for the Euro-zones peripheral countries. Since such a decision would spell instant sovereign default for those countries which would then have to borrow at pre-Euro membership interest rates. It is also not a realistic option for the Euro-zone as a whole since the default of Greece, Spain, Ireland or Portugal would cause massive losses in Europe's already beleaguered banking system. This implies that the ECB has little realistic policy alternative but to continue doing what it has been doing now for sometime, which is to hold its nose and continue to finance indefinitely, albeit through the backdoor, the Euro-zone periphery's large public borrowing needs.

Desmond Lachman is a resident fellow at AEI.